A common concern for construction business owners is how to transition their business to the next generation. Often children will work in the construction business and seek to run the business after the retirement of their parents. There are many different options to transition a business with varying considerations and tax implications with the two most common methods outlined below:
Option 1 – Freeze
In this scenario, the value of the business to date is “frozen” and attributed to the parent in the form of fixed-value preferred shares. The child then subscribes for the new common shares, meaning that any future value in excess of current value attributes to the child.
The parent can also decide at this point if they wish to maintain voting control of the business for now or provide this voting control to the child via super-voting shares. This decision impacts the accounting of the fixed-value preferred shares issued to the parent as part of the “freeze”. If the parent retains control of the corporation after the freeze, the fixed-value preferred shares are reported as equity on the company’s balance sheet at their stated capital (typically nominal value). However, if/when the parent gives voting control to the child, the fixed-value preferred shares are required to be reported as a liability on the company’s balance sheet at their fair value (typically significant value). This consideration and accounting treatment is a matter that should be discussed with your accountant as well as the users of your financial statements.
Regarding taxes, the corporation can redeem the fixed-value preferred shares owned by the parent using after-tax corporate funds. The redemption is treated as a dividend to the parent taxed personally at the value redeemed less the paid-up capital (typically nominal amount) of the redeemed shares. Often these shares are redeemed over a long period to allow the parent to take advantage of annual marginal tax rates.
Option 2 – Sale
In this scenario, the value of the business to date is “sold” by the parent to the child (using a holding company). The child then subscribes for super-voting shares to obtain voting control as a requirement for the parent to receive special tax treatment on the sale is that they give up control of the corporation as part of the transaction.
The sale of shares to the child will result in a capital gain to the parent at the current value of the business less the adjusted cost base (typically nominal amount) of the shares. Subject to the business meeting the criteria of a Qualified Small Business Corporation (QSBC) and the parent not having previously claimed the Lifetime Capital Gains Exemption (LCGE), the parent can then shelter up to $1,250,000 of this gain, avoiding personal taxes (other than minor alternative minimum tax) thereon. If the value of the business exceeds $1,250,000, the remainder is taxable to the parent as a capital gain at a 50% inclusion rate. If the child will be paying the parent over a period of time (often the case for the business to payout the parent using future business profits), the parent may also be eligible to claim a capital gains reserve, resulting in the capital gain being taxable over a period of up to ten years instead of all in the year of sale.
In the future, the child’s holding company can then be amalgamated with the existing corporation to simplify the corporate structure. The accounting impact would be a reduction to the retained earnings of the amalgamated entity equal to the value paid for the shares.
As the transition of a business can be a complex process and different for each situation, it is suggested that you seek guidance from your accountant to determine the most tax-efficient strategy for your business. In addition, a corporate lawyer and a business valuator will be required to execute the transition.
